Capital Structure, Investments, and Financing Activities

(42) Management of financial risks

Market fluctuations with respect to foreign exchange and interest rates represent significant profit and cash flow risks for the Group. Merck aggregates these Group-wide risks and steers them centrally, partly by using derivative financial instruments. To estimate existing risks of foreign exchange and interest rate fluctuations, Merck uses scenario analyses. Merck is not subject to any material risk concentration from financial transactions.

Merck uses marketable forward exchange contracts, options and interest swaps as hedging instruments. The strategy to hedge interest rate and foreign exchange rate fluctuations arising from forecast transactions and transactions already recognized in the balance sheet is set by a risk committee, which meets on a regular basis. The use of derivatives is regulated by extensive guidelines and subject to ongoing risk controls by Group Treasury. Speculation is prohibited. The strict separation of functions between trading, settlement and control functions is ensured. Derivatives are only entered into with banks that have a good credit rating. Related default risks are continuously monitored.

The Report on Risks and Opportunities included in the combined management report provides further information on the management of financial risks.

Foreign exchange risks

Owing to the international nature of its business, Merck is exposed to transactional foreign exchange risks within the scope of both its business activities and financing activities. Foreign exchange risks are continuously analyzed, and different hedging strategies used to limit or eliminate these risks.

The entire foreign exchange exposure is divided into several defined subsets with different risk profiles and systematically hedged using suitable hedging instruments. Hedging is performed based on a regularly reviewed basket of currencies. The maximum time horizon for hedging is 12 months.

Foreign exchange risks from the following transactions are economically hedged through the use of foreign exchange contracts and currency options:

• intragroup financing in non-functional currency, and
• receivables from and liabilities to third parties in non-functional currency.

Foreign exchange risks from the following transactions are hedged using foreign exchange contracts and currency options applying hedge accounting:

• forecast transactions in non-functional currency, the expected probability of which is very high for the next 12 months, and
• firm purchase commitments over the next 12 months in non-functional currency.

The following table shows the net exposure and the effects of transactional exchange rate movements of the key currencies against the euro in relation to the net income and equity of the Group on the balance sheet date:

In this presentation, effects of cash flow hedges are taken into consideration in the equity of the Group. The net exposure of each of the above currencies consisted of the following components:

• planned cash flows in the next 12 months in the respective currency, less
• the nominal values of hedging instruments of these planned cash flows.

The planned cash flows in the next 12 months are analyzed and divided into subsets in accordance with the risk management strategy. In the first subset, 25% of a regularly reviewed basket of currencies is hedged. The second subset hedges a more flexible basket of currencies selected on the basis of hedging costs and correlation with the euro. The hedging strategy achieves an economic hedge ratio of at least 40% across all hedging subsets. Depending on scenario analyses, this can be increased to up to 90% using a rule-based approach. As in the previous year, balance sheet items in the above currencies were economically hedged by derivatives in full if they did not correspond to the functional currency of the respective Group company. Accordingly, they do not affect the net exposure presented above.

The impact of cash flow hedge accounting for forecast transactions in foreign currency was as follows for the major currencies:

In addition to the transactional foreign exchange risks described previously, currency translation risks resulted from the fact that many of Merck’s subsidiaries are located outside the euro area and have functional currencies other than the reporting currency. Exchange differences resulting from translation of the assets and liabilities of these companies into euro, the reporting currency, are recognized in equity.

Interest rate risks

The Merck Group's net exposure to interest rate changes comprised the following:

The effects of a parallel shift in the yield curve by +100 or -100 basis points on the consolidated income statement, as well as on equity relative to all short-term or variable monetary deposits and monetary borrowings within the scope of IAS 32, except contingent considerations, are presented in the following table. In the event of a downward shift, the interest rate for instruments subject to a contractual interest rate floor of zero percent was limited accordingly:

Electricity price risks

As part of the implementation of its sustainability strategy, Merck has concluded so-called virtual power purchase agreements in order to cover the purchased electricity volumes in Europe and the United States with energy certificates from renewable sources. At the reporting date, agreements were in place with wind and solar farm operators in the United States and Spain. With the exception of a wind farm in the United States, the other wind and solar farms in Spain and the United States were still under construction. The fundamental structure of all of the agreements was identical, involving a fixed exercise price for Merck and the assumption of the exposure from variable spot energy prices in the respective market regions. Merck receives green electricity certificates for the volumes of electricity produced and attributed to Merck. Merck uses the certificates it receives solely for itself. The agreements have remaining terms of between 10 and 17 years as of the reporting date.

In financial terms, the most important agreement is the one concluded between Merck and a wind energy project developer in the United States for an installed capacity attributable to Merck of 68 megawatts. The wind farm was commissioned in fiscal 2022. The fair value of the agreement was € 44 million as of the end of the reporting period (2022: € 50 million). The electricity price of around 40 % of the expected production volume under this virtual power purchase agreement is hedged by a separate hedging instrument. Consequently, the net effect of the fixed price for the virtual power purchase agreement is zero for this quantity. The accounting provisions on hedge accounting were not applicable.

In total, the agreements including the hedging instrument resulted in a net gain on fair value measurement of € 3 million (2022: € 16 million) that was recognized in other operating income.

A change in the material valuation parameters would have had the following impact on the fair value of the agreements excluding the hedging instrument:

Liquidity risks

The risk that Merck cannot meet its payment obligations resulting from financial liabilities is limited by establishing the required financial flexibility and by Group-wide cash management. Information on issued bonds and other sources of financing can be found in Note (37) “Financial debt/Capital management”.

Liquidity risks are monitored and reported to management on a regular basis.

The following liquidity risk analysis presents the undiscounted, contractually fixed cash flows such as repayments and interest on financial liabilities and the net cash flows of derivatives with a negative fair value:

Credit risks

Credit risk for Merck means the risk of a financial loss if a customer or other contract partner is not able to meet its contractual payment obligations. Merck is exposed to credit risks mainly due to existing trade accounts receivable, other receivables, other debt instruments, derivatives and contract assets.

Credit risks are monitored on an ongoing basis. The risks arising from extending credit to customers and in the course of other business relationships are also managed.

Merck analyzes all trade accounts receivable that are more than 90 days past due in order to establish whether default exists. In addition, all other financial instruments that are more than 30 days past due are examined in order to establish whether there has been a significant increase in the credit risk. Both methods are used to examine whether there is objective evidence of an impairment requiring the recognition of additional loss allowances.

The following table shows impairments for financial assets from operative transactions and contract assets as well as gains from their reversals recognized in the consolidated income statement:

The loss allowances and reversals recognized for trade accounts receivable as shown above applied entirely to receivables resulting from contracts with customers. The increase in loss allowances for trade accounts receivable was mainly attributable to a distribution partner in the Healthcare business sector in a mid-double-digit million-euro amount.

Credit risks from trade accounts receivable

The credit risk from trade accounts receivable is largely impacted by the specific circumstances of individual customers. Merck also considers additional factors such as the general default risk in the respective industry and country in which the customer operates.

The credit risk of customers is assessed using established credit management processes. This is done in particular by analyzing the aging structure of trade accounts receivable.

Merck continuously reviews and monitors the open positions of all its customers in the corresponding countries and takes steps to mitigate credit risks if necessary.

The tables below contain an overview of the credit risk by business sector and country rating as established by leading rating agencies:

Goods were generally sold under retention of title so that a reimbursement claim existed in the event of default. Other guarantees generally were not demanded. The scope of credit-insured receivables was immaterial for Merck.

Loss allowances based on expected credit losses for trade accounts receivable as of December 31, 2023, were as follows:

Loss allowances based on expected credit losses for trade accounts receivable as of December 31, 2022, were as follows:

Credit risks from other receivables

Gross other receivables amounted to € 160 million as of December 31, 2023 (December 31, 2022: € 136 million). Other receivables of € 157 million were allocated to Level 1 of the three-level impairment model (December 31, 2022: € 126 million), meaning that the credit loss expected in the next 12 months was used to determine the amount of impairment when examining the individual credit risk of the respective contract partner. In addition, non-current leasing liabilities amounting to € 3 million (December 31, 2022: € 2 million) were allocated to Level 2 of the simplified impairment model. The next table shows the impairment losses recognized for other receivables.

Credit risks from other financial assets

Merck limits credit risks from other financial assets by entering into contracts almost exclusively with contract partners whose creditworthiness is good. The credit risk from financial contracts is monitored daily on the basis of market information on credit default swap rates and regularly on the basis of rating information.

Impairment losses on financial assets developed as follows:

Changes in the expected credit loss rates used in the simplified impairment model did not result in any significant changes in the additions to and reversals of impairment losses in Level 2.